Look-Through Earnings

Look-through earnings is a concept famously championed by Warren Buffett to determine a company's true economic performance. Think of it as putting on a pair of X-ray glasses to see past the often-misleading figures of standard accounting. Traditional net income, as dictated by GAAP (Generally Accepted Accounting Principles), doesn't always capture the full picture, especially for a company that owns significant chunks of other businesses. Look-through earnings correct this by adding a company's proportional share of the undistributed earnings from its investments to its own reported profit. This provides a more realistic measure of the value being generated for shareholders, recognizing that earnings reinvested by an investee company are just as valuable as the earnings of the parent company itself. It’s an essential tool for investors wanting to understand the real earning power of conglomerates and holding companies like Berkshire Hathaway.

Standard accounting rules can feel a bit like looking at a business through a keyhole. You see a part of the room, but you miss the bigger picture. Here's why that happens and how look-through earnings provide a panoramic view:

• The Accounting Blind Spot: When a company owns a non-controlling stake in another firm (typically less than 50%), its income statement usually only reflects the dividends it receives from that investment. But what about the earnings the investee company kept and reinvested to grow its business? Standard accounting largely ignores this, yet those retained earnings are working hard to create future value for the parent company.
• Economic Reality vs. Accounting Rules: A dollar earned and reinvested by an investee is, from an economic standpoint, just as valuable to the shareholder as a dollar earned directly by the parent company. Look-through earnings bridge this gap by treating all earnings proportionally, regardless of where they were generated or whether they were paid out as dividends. This aligns your analysis with the underlying business reality, a cornerstone of value investing.

Calculating look-through earnings isn't rocket science, but it does require a bit of detective work in a company's annual report. The goal is to see what the company's income statement would look like if it fully included its share of earnings from its major investments.

Begin with the company's reported net income. This is your baseline figure.

If a company uses the equity method for an investment (typically for ownership between 20% and 50%), a portion of that investee's earnings is already included in its net income. You must subtract this amount to avoid double-counting. This figure is often found on the income statement as “Equity in earnings of affiliates” or a similar line item.

Now for the fun part. For each major investment, you find the investee's total earnings for the year and multiply it by your company's percentage ownership. Formula: (Investee Company's Net Earnings) x (% Ownership) = Your Look-Through Share You do this for all the company's significant holdings and add the total to the adjusted figure from Step 2.

Imagine “Global Holdings Inc.” reports net income of $10 billion.

1. It owns 15% of “Future Tech Corp.,” which earned $2 billion this year. Since Global owns less than 20%, it likely only booked the dividends it received, not the earnings.
2. It also owns 25% of “Steady Eddies Co.,” which earned $1 billion. Global uses the equity method here, and its income statement already includes $250 million (25% of $1 billion) from this stake.

To calculate Global's look-through earnings:

1. **Start with reported earnings:** $10 billion.
2. **Adjust:** Subtract the $250 million already included from Steady Eddies: $10 billion - $250 million = $9.75 billion.
3. **Add the look-through shares:**
  * Future Tech: 15% x $2 billion = $300 million
  * Steady Eddies: 25% x $1 billion = $250 million
  * Total to add: $300 million + $250 million = $550 million.
4. **Final Calculation:** $9.75 billion + $550 million = **$10.3 billion**.

Global's true economic earning power is $10.3 billion, a full $300 million higher than its reported net income suggests!

This isn't just an academic exercise; it has powerful practical applications.

• A Truer P/E Ratio: The price-to-earnings ratio (P/E) is a go-to metric for valuation. If you calculate it using reported earnings, a company like Berkshire Hathaway might look expensive. But if you substitute look-through earnings for the “E” in P/E, the ratio often drops significantly, revealing a much more attractive valuation. It shows you the price you are paying for the actual, underlying earnings power.
• Identifying Hidden Value: Companies with large, undeclared earnings power hidden in their investment portfolios can be fantastic, under-the-radar opportunities. The market, which often focuses lazily on headline numbers, may be undervaluing them. By doing the look-through homework, you gain an analytical edge.

While powerful, the look-through concept isn't a silver bullet. Keep these points in mind:

• It's an Estimate: The calculation requires digging through financial statements and making some judgments. It's more of an art than a precise science.
• No Direct Control: The parent company doesn't have direct access to the retained earnings of its investees. It relies on the investee's management to allocate that capital wisely. You are betting on two sets of managers, not just one.
• Best Use Case: This tool is most effective for analyzing holding companies and conglomerates whose business models are built around owning stakes in other entities. For a simple manufacturing company with no major investments, the metric is far less relevant.